Dramatic Income Tax Changes Ahead for Colorado-Based Service Corporations
Colorado House Bill 18-1185 was recently signed into law by Colorado Governor John Hickenlooper, and it is first effective for taxable years beginning on or after January 1, 2019. This law will require C corporations and S corporations to use a market-based sourcing methodology for apportioning their sales of services and intangible property. Historically, Colorado has required this type of revenue to be apportioned using a proportional cost of performance methodology.
Corporations that should experience the largest change in their Colorado apportionment percentage as a result of this law, include those that operate accounting, legal, advertising, professional service, and consulting firms, as well as corporations selling software as a service (SaaS).
For example, if a corporation that sells SaaS has 100 percent of its operations located inside of Colorado, 90 percent of its revenue from services delivered outside of Colorado, and 10 percent of its revenue from services delivered inside of Colorado, it would experience a 90 percent shift in Colorado taxable income as a result of HB 18-1185.
Because the law only affects the apportionment of the sales of services and intangibles, it does not affect the way a manufacturing company or a retail company would source its receipts from its sales of tangible products.
Under HB 18-1185, partnerships (including limited liability companies that are federally taxed as partnerships) are generally still required to source the income of any nonresident individual partners under Colorado’s nonresident individual sourcing laws. However, partnerships may elect to source this income by using the Colorado allocation and apportionment rules as they exist prior to January 1, 2019.
Apportionment: the tool to calculate state taxable income
Why does this law have such a dramatic effect on service companies? HB 18-1185 changes the process for calculating the numerator of Colorado’s sales apportionment factor. When a business operates in more than one state, each state must determine how much income from the business it may tax. The tool that states generally use to divide up taxable business income among themselves is apportionment.
The following examples illustrate the impact of HB 18-1185 on a service company.
Both before and after the enactment of this new law, taxable income in Colorado is calculated by dividing a business’ sales in Colorado by sales everywhere else, and then multiplying the result by net business income.
Prior to HB 18-1185, the amount of revenue from the sale of services that was included in the seller’s Colorado sales factor numerator was calculated by dividing the cost of providing that service in Colorado by the cost of providing that service everywhere else. This fraction is multiplied by the gross sales from the service to calculate service sales in Colorado.
In contrast, HB 18-1185 fundamentally changes the formula for calculating “service sales in Colorado.” Effective for taxable years beginning on or after January 1, 2019, the issue of what costs were incurred in providing a service or where those costs were incurred is irrelevant to computing the seller’s Colorado sales factor.
The new formula calculates “service sales in Colorado” with the following formula:
First, a sale is in Colorado if it is “delivered” in Colorado. Put another way, a service is received in Colorado if the benefit is received in Colorado.
Sales from services delivered in Colorado are divided by sales everywhere else.
This number is then multiplied by gross sales from services to yield service sales in Colorado.
Service sales in Colorado are then divided by sales everywhere else and multiplied by net business income to calculate Colorado taxable income.
Colorado factor presence considerations
As a result of this new sales apportionment sourcing law, coupled with Colorado’s economic nexus law which has existed for income tax purposes since 2010 and single sales factor, out of state service corporations will likely see increased apportionment factor and tax liability in Colorado. Additionally, service corporations with a significant physical presence (property and payroll) in Colorado could see a reduction in their apportionment factor and tax liability.
How we can help
CLA’s state and local tax professionals are actively monitoring these developments. We can advise you on the effect that Colorado’s new market sourcing law will have on your business.